Choosing Investment Managers: A Guide for Institutional Investors

As investment practitioners, we all know that we are supposed to avoid the curse of buying high and selling low. After all, that's what so-called mom-and-pop investors do. Institutional investors — you know, the multibillion dollar endowments, pension funds, and the like that hire professional managers with the help of sophisticated consultants — are the ones making all the right moves. Right? Wrong.

Many institutions, even the large, sophisticated plan sponsors, end up buying high and selling low when it comes to hiring investment managers. How can that be? Many institutions hire managers who are in favor and fire them when they are out of favor, only to hire a different manager who exhibits a better performance record — often harming the performance of their own plan assets. This is what is known in the trade as "chasing performance."

Why would they do this? Shouldn't they be more sophisticated about navigating the pitfalls of investing? Well, behavioral finance provides us with some clues. So do agency costs. And the interaction between the two can create a truly lethal mix. The problem isn't just found in suboptimal performance. These hidden costs stand in direct conflict with institutional investors' fiduciary duty to clients and beneficiaries.

To understand why the basic principles of investing so often go awry, one must first revisit the complexity of the institutional investment business. It is composed of institutional clients, investment consultants, and investment firms. Each group performs various roles in the investment of plan assets. Institutional clients are typically composed of board members overseeing the administration of a given plan, such as public pension funds, corporate pension plans, endowments, and foundations. These clients and their board members may or may not have the requisite financial expertise and often hire outside investment consultants to advise on the asset allocation of plan assets, as well as the hiring and oversight of investment managers. Investment managers are the ones that deploy plan assets in some way.

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Each of these players has a fiduciary duty to carry out what is in the best interest of the client or beneficiaries. Some players, no doubt, do this well and faithfully execute their responsibilities. Other players . . . not so much. Unfortunately, we have come to a point in time in which there is a great deal of activity that acts against the best interests of clients — sometimes from the clients themselves!

Of course, at the center of the institutional investment supply chain are money and people. Unfortunately, when these two ingredients mix, truly anything can happen. All the factors of human psychology and emotion come into play: ego, desire, greed, fear, arrogance, deceit, etc. Of course, these "human elements" are a danger to any investor-client relationship — but institutional investment relationships typically involve three parties acting on behalf of the institutional client. So, these human failings can be amplified by agency costs, taking the complexity to a whole new level.

For instance, an elected trustee on a public pension board may be motivated to fire an underperforming manager to avoid a political fight, even if that decision is unwarranted on a financial basis. Rather than evaluate a given investment manager based upon that firm's merits, the board discontinues the relationship to avoid the appearance that it is doing nothing while the funds are underperforming. Alternately, another trustee might be shaken by a dramatic market event and want to take actions solely in response (recency heuristic, fear, etc.), ignoring or altering the strategic investment policy. In yet another example, perhaps a client fears that the manager is not keeping pace with powerful market trends, thereby pressuring the manager to deviate from his style.

Even when managers recognize that changing style is a poor investment decision, they might nevertheless participate in what is fashionable merely to keep or gain clients. Of course, this exact scenario happened en masse during the technology bubble of the late 1990s; many value and growth-at-a-reasonable-price, or GARP-style managers were forced to participate in dot-com era stocks or lose clients. In all these examples (and countless real-life events), each of the three parties to the institutional relationship must grapple with these highly consequential human elements. Naturally, all of these pressures are obstacles to the objective evaluation of and choice of managers.

Even though client fears are easily put to rest with strong performance, a condition of having strong performance is taking positions that differ materially from the market. It's as simple as that. Sometimes, an investment process suffers through a period in which it just doesn't work. This occurs for many reasons — people reasons, limitations of models, mistakes, whatever. And every investor deals with this. When it comes to strong, long-run performance, occasional underperformance — even among exceptional investment firms — is the norm, not the exception. In fact, a study of the top decile managers over a 10-year time frame revealed that some 90% of these outstanding managers had a three-year stretch in the bottom decile at some point in that same decade. Yet, institutional clients and their consultants still fire managers who have underperformed their benchmark and hire those that have recently outperformed their benchmark. In short, just like the retail market, in which the average mutual fund investor underperforms the average mutual fund by 600 basis points or more, many institutions chase investment performance as well — to the detriment of their clients and plan beneficiaries.

Virtually all investment firms experience at least a rough patch, if not downright poor performance for some stretch of time. So, in examining investment performance for the purpose of choosing managers, what's a client to do? There are lots of reasons that investment managers perform well or poorly. Sometimes this is good. Sometimes this is bad. Of course, some of these situations are straightforward. On the one hand, you can be right on your investment thesis and get rewarded by the market. For instance, buying many tech stocks in 2002 was a good call, as many of these names could be bought for less than the cash on the balance sheet (getting the business — and often times a good business — for free). Alternately, you can be wrong on the thesis and the market teaches you a harsh lesson. For instance, owning Enron in 2001 was a mistake.

But success and failure can be more complicated still. You can make wise decisions and look foolish for some (often uncomfortably long) time because the market disagrees with you. For instance, avoiding mortgage-related names or home builders in 2005–2006 was right on a fundamental basis, yet doing so would have caused you to underperform the market, as these issues climbed dramatically during that period. Alternately, you can make a foolish decision and still get rewarded by the market as various securities or sectors are in favor. For instance, the performance of tech stocks in 1998–1999 was so strong that a material overweight in technology names was almost a prerequisite for outperforming a benchmark during that era, even if the fundamentals could not possibly justify the prices. Ultimately, investment choices can be evaluated in four ways as noted in Exhibit 2.

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Of course, this can happen at the individual security level, but it can also happen at a sector or even thematic level. For instance, in the mid- to late 1990s, recognizing how technology and the Internet was transforming business models, many investors overweight in technology and telecom were handsomely rewarded. Likewise, investors who were underweight for the popping of the tech bubble likewise outperformed. Then, overweights in commodities, mortgage, or housing-related securities were big drivers in the early to mid-2000s. And so on. So, investors can get these themes right or wrong. And they can get the market's perception of these themes right or wrong as well.

If investors can have good performance for the wrong reasons (good luck) and bad performance for the right reasons (bad luck), in addition to having good performance for the right reasons (skill) and bad performance due to mistakes (bounded rationality), how can one judge anybody? No wonder the selection of managers seems so convoluted sometimes.

Traditionally, investment managers have been assessed by looking at the four Ps: people, process/philosophy, portfolios, and performance. However, this approach has failed to arrest the significant behavioral and agency costs mentioned earlier. Performance is analyzed ad nauseum, using peer-group comparisons, sophisticated performance attribution analysis, and so forth. Yet, manager selection often comes down to chasing performance, which has been shown time and time again to be an inferior approach.

So, can manager investment philosophy be a useful differentiator? To be sure, some philosophies probably are better than others, but there are no doubt good and bad managers in every category. Active management comes down to wolves and sheep — and the wolves EAT the sheep. So, it all comes down to execution and judgment. Philosophy by itself tells us nothing. If it's not philosophy, can investment process help us differentiate good managers from bad? Process is no doubt important, but what makes one process successful and another one unsuccessful? Surely every manager is trying their level best to be successful, however they define it!

Managers can describe processes until they are blue in the face, but what good is a sophisticated process if it is unwieldy and impractical to execute? Ultimately, success in any endeavor is determined by talent, skill, and motivation. Here is where we separate the wolves from the sheep. Of the three attributes, skill is perhaps the easiest to assess. How much relevant experience? What kind of educational pedigree? What kind of track record? How many CPAs, CFA charterholders, PhDs, or even rocket scientists do they employ? This more or less captures standard, generally recognized skill sets.

The solution to all this is found by keeping close tabs on a relatively small number of managers by keeping a log of the manager's investment decisions. This log needs to be flexible enough to accommodate the various manager styles, specific enough to capture the manager's successes and failures (i.e., Exhibit 2), and long enough to capture the successes and failures of a large sample of the managers "bets."

Ultimately, understanding a manager's intentions at the time each choice is made is the only way to differentiate luck and skill over time. If all parties in the institutional relationship are privy to the manager's record of achievement by looking at discrete investment decisions, good things happen. The board members can emphasize the discrete investment-decision record to justify sticking with a manager. The consultant can use it to compare the strengths and weaknesses of various investment firms. Lastly, investment managers themselves can use it to better understand and improve upon their own weaknesses. By separating skill from luck, this approach advances the state of the entire investment industry and better helps us fulfill our fiduciary duty in the process.